How Schlubs Get Taken By Wall Street Pros

Let us count the ways. Here though I want to focus on one way in particular that ordinary Americans are short-shrifted by Wall Street, and how even the brightest folks can fail to see how the losses pile up. Kevin Drum noted that for a price pro-traders could get access to the Michigan Consumer Sentiment report a few seconds early. Drum's spidey sense told him that this must be bad for Main Street, but Reuters Blogger Felix Salmon pushed back, tweeting:

Dear @kdrum, how exactly are ordinary schlubs being taken to the cleaners here?

Felix is no apologist for Wall Street excess. His response is - I assume - predicated on reasoning that's second nature for economics and finance types. The reasoning goes something like this: Yes, the traders had better information and therefore were likely to earn above average profits because of it. However, the people the folks that they traded against went into the trade willingly and with no less information than they would have had anyway. So, how exactly is anyone harmed?

The harm comes not at the level of the individual trade, but the market as a whole. Bear with me, this is no hippy-dippy moralizing.

When Joe Sixpack invests in the market he - if he's realistic - diversifies heavily and expects to earn the average long term return for a retail investor. That return, however, is very lumpy. Some days, Joe Sixpack's savings will happen to go into the market right before a big correction. Some days it will go in right before a big rally. When the ups and downs are averaged out, that's Joe's buy-and-hold return.

When traders take advantage of paid early information they shift that balance. Now, when there is a surprise rally coming traders with access to early information jump in en masse. This means that buyers in the queue just before a big run-up will be disproportionately pro traders. They'll receive a greater share of the low early prices and Joe will be more likely to pay the later high price.

On a down information, just the opposite happens, the traders are all on the sell side and Joe Sixpack's savings are now much more likely to be towards the front of the queue where he will buy in at slightly higher prices.

Now, given the opportunities available to him, Joe is still doing the best he can and willingly entering into trades. However, the best he can realistically expect to do - the long run retail average - is now lower. He accepts a slightly worse deal because a better deal is simply not available to him.

Each time pro traders with proprietary information load up on one side of a trade they nick ever-so-slightly the return to the average Joe. Year-after-year it adds up to an environment where the average retail return is going to be lower than the average pro return. And, since the stock market is likely the best long term investment available to the average Joe, the average Joe's best chance at financial success is diminished.

Economists will note that this - in theory - has economy wide implications. The return to capital falls and the return to information management rises. Economic agents and firms expend socially valuable resources on the socially useless pursuit of restricting and metering the flow of information.

Snarky readers will ask - doesn't this mean that pay-for-content media is socially destructive? In and of itself, yes. The socially productive part is creating the media content in the first place. After that, the freer the distribution the better. Ideally consumers would tip content providers an amount exactly equal to how much the consumer enjoyed or found it useful. Then content providers would be motivated to produce stuff that folks enjoyed but no one would be barred from consuming media because the price was too high.